modeling-capital-budgeting-decisions

# Modeling Capital Budgeting Decisions

Builds NPV, IRR, and payback models for capital investment decisions with hurdle rate calibration and risk adjustment.

## When To Use

- Evaluating a proposed capital expenditure (new plant, equipment, technology platform, acquisition)
- Comparing two or more mutually exclusive projects competing for the same budget
- Setting or recalibrating a corporate hurdle rate for investment approvals
- Stress-testing an already-approved project under revised macro or operational assumptions
- Building a capital allocation ranking framework across business units or divisions

## Inputs To Gather

- **Project cash flows**: Initial outlay (CapEx), annual operating cash inflows/outflows, terminal or salvage value, and project life in years
- **Cost of capital components**: Risk-free rate, equity risk premium, beta (levered/unlevered), pre-tax cost of debt, target capital structure weights, marginal tax rate [VERIFY: tax rate by jurisdiction]
- **Hurdle rate policy**: Whether the firm uses a single corporate WACC, divisional hurdle rates, or project-specific rates; any stated premium above WACC for risk categories
- **Tax and depreciation schedule**: Depreciation method (straight-line, MACRS, declining balance), applicable asset class lives [VERIFY: depreciation schedules per local tax code]
- **Working capital requirements**: Incremental net working capital at launch, annual changes, and release at project end
- **Risk parameters**: Probability-weighted scenario definitions (base, upside, downside), key variable ranges for sensitivity analysis, correlation assumptions if running Monte Carlo

## Workflow

1. **Establish the discount rate**
   - Compute WACC from current capital structure, adjusting for project-specific risk if the investment's risk profile differs materially from the firm's overall portfolio
   - If divisional hurdle rates apply, confirm the appropriate segment rate and any board-mandated spread
   - Document whether the rate is nominal or real and ensure cash flow projections match

2. **Build the free cash flow projection**
   - Lay out year-by-year unlevered free cash flows: EBITDA − taxes on EBIT + depreciation tax shield − CapEx − ΔNet Working Capital
   - Include any phased investment (multi-year build-out) and ramp-up curves for revenue
   - Model terminal value using either perpetuity growth (Gordon Growth) or exit multiple, stating which and why

3. **Compute primary metrics**
   - **NPV**: Discount all FCFs at the hurdle rate; positive NPV = value-creating
   - **IRR**: Solve for the rate that zeroes the NPV; flag non-conventional cash flow streams where multiple IRRs may exist
   - **Payback period**: Simple (undiscounted) and discounted payback; note corporate policy threshold if one exists
   - **Profitability Index (PI)**: NPV ÷ initial investment; useful when capital is rationed across multiple projects

4. **Run sensitivity and scenario analysis**
   - One-variable sensitivity: toggle revenue growth, operating margin, discount rate, and CapEx ±10–20% to identify the highest-impact driver
   - Scenario matrix: define base / bull / bear cases with coherent assumption sets (not just single-variable swings)
   - Optional: Monte Carlo simulation with probability distributions on 3–5 key inputs; report P10 / P50 / P90 NPV outcomes

5. **Rank and recommend**
   - If comparing projects, present a ranking table by NPV, IRR, PI, and payback
   - Highlight conflicts (e.g., IRR ranking differs from NPV ranking due to project scale differences) and explain which metric should govern
   - State whether the project(s) clear the hurdle rate and by what margin

## Output

The deliverable is a structured capital budgeting model containing:

- **Assumptions table**: Every input clearly listed with source, date, and [VERIFY] flags where data needs confirmation
- **FCF schedule**: Year-by-year projection with line-item detail
- **Metrics summary**: NPV, IRR, payback (simple and discounted), PI — each with a brief interpretation
- **Sensitivity dashboard**: Tornado chart or table showing NPV sensitivity to each key variable
- **Scenario summary**: Base / bull / bear NPV and IRR with narrative on what drives each case
- **Recommendation**: Clear accept/reject/defer conclusion tied to the firm's hurdle rate policy and capital constraints

## Quality Checks

- NPV at the IRR equals zero (mechanical cross-check)
- Cash flows are internally consistent: depreciation ties to CapEx schedule, tax shield ties to depreciation, working capital release nets to zero over project life
- Discount rate is applied consistently (nominal-to-nominal or real-to-real; no mixing)
- Terminal value does not exceed 60–70% of total project NPV without explicit justification — if it does, flag concentration risk
- All tax rates, depreciation lives, and regulatory incentives carry [VERIFY] tags referencing the applicable jurisdiction
- Sensitivity ranges are realistic (not artificially narrow to make the project look safe)
- If IRR is used as the primary decision metric for mutually exclusive projects, confirm that the reinvestment rate assumption is appropriate; prefer NPV when projects differ in scale or timing